Controlled Groups and the Sec. 179 Election for S Corporations

Regs.
Sec. 1.1563-1(b)(2)(ii)(C) excludes an S
corporation from being treated as a
component member of a controlled group
“for purposes of any tax benefit item
described in section 1561(a) to which it
is not subject.”

Sec. 179(d)(6) states that component
members of a controlled group are
treated as a single taxpayer for
purposes of that section’s limitations
on qualifying property that may be
expensed in a tax year. However, in
light of the regulatory language under
Sec. 1563, it was not clear that an S
corporation in a controlled group should
not be treated as a component member of
the controlled group for this
purpose.

In response to the AICPA’s request
for clarification, the IRS Office of
Chief Counsel recently released a
memorandum, which states that for
purposes of the controlled-group rules
of Sec. 179, an S corporation is treated
as an excluded member of a controlled
group and may therefore apply the full limitation amounts of Secs. 179(b)(1) and (2) independently of other
members.

Since the inception of subchapter S in
1958, the relationship of this part of the Code to
other tax rules governing corporations has been
unclear. In 1982, Congress stated that the rules of
subchapter C apply to S corporations unless those
rules are inconsistent with the purposes of
subchapter S.1 However, one of the
basic rules regarding the taxation of S corporations
is that the corporation computes its income in the
same manner as an individual.2 Since the adoption of
these two provisions more than 30 years ago, no
regulations have amplified them, and cases and
rulings have been few and narrow in scope.

The gray areas become even grayer when a
particular rule is not within subchapter C and is
clearly inapplicable to individuals. Examples
include the income exclusion under Sec.
118 for contributions to capital. This
provision applies specifically to corporations but
is not within subchapter C. Cases and rulings have
implicitly allowed S corporations to exclude
contributions to capital from income.3

Controlled Groups
of Corporations

Another area of importance
is the controlled group problem. Secs. 1561 and
1563, which define and limit tax benefits of certain
controlled corporations, are not within subchapter C
and are not relevant to the individual
taxpayer. Thus there is no direct link from
any provision in subchapter S to these Code
sections.

Sec. 1561 enumerates certain
attributes, such as the graduated corporate rate
structure, as items that members of a controlled
group must share. However, the sharing is limited to
the “component” members and does not apply to
“excluded” members. Sec. 1563, which defines the
relationships necessary for two or more corporations
to be included in a controlled group, does not
specifically include or exclude S corporations.

Regulations

Historically, the regulations
have not been terribly helpful in providing
guidance. Before December 2006, only one terse
statement dealt with the status of S corporations
and the controlled group rules. Regs. Sec.
1.1563-1(b)(2)(ii)(c)4 excluded an electing
small business corporation (S corporation) if it was
“not subject to the tax imposed by section
1378.”5 That tax, on “certain
capital gains,” was the predecessor of the current
built-in gains (BIG) tax and required an S
corporation to use the graduated Sec. 11 rate
schedule in certain instances when it was subject to
the tax.

By the end of 2006, almost 24 years
had passed since the effective date of the
Subchapter S Revision Act of 1982. Moreover, 20
years had elapsed since Congress had replaced the S
corporation capital gain tax with the BIG tax.
Treasury finally in December 2006 issued temporary
and proposed regulations that correspond with the
changed nomenclature and cross references, as well
as recognize that the passive investment income tax
and the BIG tax did not use the graduated rate
structure of Sec. 11.

The preamble to the
2006 temporary and proposed regulations stated:

Since an S corporation is not currently subject to any tax to which either the tax
bracket amounts of section 11(b) apply, or any
other tax benefit item to which section 1561(a)
applies, it is appropriate to treat that
corporation as an excluded member of a controlled group.6

These proposed
regulations were adopted as final without
substantive change in May 2009, and the temporary
regulations were removed.7

If one were to read
the preamble to the temporary and proposed
regulations before seeing the regulations, one would
expect to see that the regulations would treat S
corporations as excluded members without further
qualification. However, the operative language of
the regulation defining excluded members contains a
clause that the preamble does not explain: An
excluded member includes “[a]n S corporation (as
defined in section 1361) for purposes of any
tax benefit item described in section 1561(a) to
which it is not subject”8 (emphasis added).

Thus, the regulation implies that an S
corporation might be a component member of a
controlled group of corporations when another Code
provision apportions any attribute among such
members. However, the description of component
members in the same regulation makes no mention of S
corporations. Thus, a reasonable interpretation of
the regulation would be that an S corporation is a
component member for purposes of Code provisions
other than Sec. 1561. However, the language of the
preamble appears to universally exclude S
corporations from component membership status.

Current
Interpretations

Thus, for some purposes, such
as credits, nondiscrimination plans, and accounting
method rules, the entire group, both excluded and
component members, must aggregate their
activities.13 The related-party
rules under Sec. 267 also apply to members
(component and excluded) of a controlled group of
corporations,14 although there are
certain modifications of the disallowance rules, and
of the parent-subsidiary group definition.15 Therefore, it seems
clear that an S corporation must observe the
controlled-group rules with respect to these
issues.

Sec. 179

In the context of the
Sec. 1561 attributes, it would make little sense to
subject an S corporation to a portion of the
graduated rate schedule or the other attributes that
are irrelevant to determining the taxable income of
an S corporation or of its shareholders, none of
whom may be taxable corporations. However, numerous
other rules refer to controlled groups of
corporations and do not explicitly include or
exclude S corporations. A prime example is Sec. 179,
which has several references to component members of
controlled groups of corporations. One of these
references is part of the definition of “purchase,”
which is a prerequisite for qualifying for the
expensing election. Among other limits, a purchase
from one member of a controlled group by another
member disqualifies the purchaser from expensing the
property.16

Sec. 179 requires
apportionment of three limitations among component members
of a controlled group of corporations:17

The
dollar limitation ($500,000 for 2013) of the
aggregate cost of qualified property that may be
taken into account during a tax year.18

The
reduction in limitation threshold for taxpayers
placing Sec. 179 property in service during the
year ($2 million for 2013).19

The
limitation based on taxable income from trades or
businesses before claiming the Sec. 179
deduction.20

Examples Comparing C Corp. and S Corp.
Treatments

In all examples, Ess Inc. and Subs
Inc. are S corporations. See Inc. and Sea Inc. are C
corporations. Moreover, all of the corporations in
each example have identical ownership, and five
individuals own all the stock in identical
proportions. No corporation is a direct owner of the
stock of any of the others. Thus, if all were C
corporations, they would clearly be component
members of the same brother-sister controlled group.
No other corporations’ ownership would include them
in the same group.

Example 1: Ess, Subs, See, and Sea each placed in
service $600,000 of qualified Sec. 179 property in
2013. Since the Sec. 179 deduction is not an
attribute listed in Sec. 1561, the corporations
need to determine which, if any, of them must
combine limitations with the others.

All four corporations are members of a single
controlled group of corporations. If they are all
treated as component members, they would need to
apportion a single expensing limit. Moreover, since
their combined Sec. 179 property placed in service
for the year is $2.4 million, reducing the $500,000
limitation by $400,000, the expensing limit for the
four corporations combined would be $100,000.

Guidance From the IRS

The AICPA S Corporation Technical Resource
Panel requested guidance from the IRS on whether S
corporations should be considered component
members for purposes of this rule, since it is not
one of the Sec. 1561 attributes. The IRS responded with a
position that is consistent with the preamble to
the 2006 proposed and temporary regulations cited
above, that an S corporation “is treated as an
excluded member of a controlled group.”21 The Office of Chief Counsel thus does not
regard the phrase “for purposes of any tax benefit
item described in section 1561(a) to which it is
not subject”22 as limiting the treatment of an S corporation
as an excluded member to situations involving tax
benefits of Sec. 1561.

Example 2: Applying the same facts as Example 1, See and
Sea would be allowed a combined $500,000 of
expensing for 2013, since they are both component
members of a brother-sister controlled group.
However, Ess and Subs are excluded members. Thus,
neither of these corporations needs to combine its
limits with the C corporations or with each other.
Sea and See together have placed in service $1.2
million of qualifying Sec. 179 property in 2013,
well short of the $2 million limitation reduction
threshold. Sea and See would allocate the $500,000
limit between them.

Ess and Subs
would not consider property placed in service by
either of the other two corporations, and each would
have $600,000 of qualifying Sec. 179
property placed in service. However, Ess and Subs
would need to watch this election carefully,
especially if any of the common
shareholders assumed more than 50% of
both corporations such that a total of more than
$500,000 were allocated to one taxpayer. The
$500,000 limit applies to each
shareholder.23

There could also be a trap if two shareholders are married and file a joint return and in
combination own more than 50% of the total shares of both corporations, since the $500,000 limit
applies both at the corporation and at the shareholder levels.

Example 3: K and L are husband and
wife. K
owns 60% of Ess, and L owns 60% of
Subs. Even though Ess and Subs might each be able to
claim a $500,000 Sec. 179 deduction in
2013, this would be an ill-advised move. With the
maximum elections, K and L would each be
allocated $300,000 of Sec. 179
deductions in 2013.

However, on a joint
return, they can claim only a $500,000 Sec. 179
deduction because they are treated as a single
taxpayer.24 Filing separately
would not help, because the limit would become
$250,000 for each.25 Thus, either filing
status costs the couple $100,000 of tax benefit. To
add insult to injury, no provision allows for a
carryover of excess Sec. 179 expensing
unless the excess results from the taxable income
limitation. That was not the problem with these
taxpayers. There are still other negative
results. K and L would each need to reduce stock (and/or debt)
basis by the full $300,000 allocated to him or
her. Each S corporation would reduce its
accumulated adjustments account by the entire
$500,000 elected, even though some of this
election provides no tax benefit in any year to
some of the shareholders.

The
treatment of the S corporations as excluded members
would also have an effect on intercompany transfers
of potentially qualifying Sec. 179 property. A
“purchase” for this purpose may not include an
acquisition of property by one component member from
another component member of a controlled group of
corporations.26 It appears that this
restriction does not apply if the buyer or the
seller (or both) is an excluded member and neither
is a component member. However, this allowance has
little application, in that a purchase does not
include an acquisition from a person or entity with
respect to whom a loss transaction would be
disallowed by Sec. 267.27 Among the
relationships specified in Sec. 267 are members of
the same controlled group of corporations.28 This rule makes no
distinction between component members and excluded
members, so mere “membership” is sufficient to
disallow losses and thus to disallow the benefits of
Sec. 179 for property purchased by one member from
another.

Example 4: Subs purchased
$300,000 of the property from Ess and $300,000 from
See. Although Subs is not a component member with
Ess or See, all three are related within the meaning
of Sec. 267. Thus, none of the property purchased
from either of these corporations is eligible for
the expensing election.

The exclusion of S corporations from component
membership may be a mixed blessing. Perhaps the
one area in which “more is always better” in the
Sec. 179 rules is the taxable income limit. In any
given year, a taxpayer cannot claim a Sec. 179
deduction in excess of taxable income from trades
or businesses. For a C corporation the taxable
income limitation is not reduced for any net
operating loss deduction.29 However, this limit, as well as those on the
maximum expensing amount and the maximum property
placed in service, requires combining the taxable
incomes of all component members of a controlled
group of corporations.

Example 5: Assume that Sea had
purchased $100,000 of qualifying Sec. 179 property.
Sea had $750,000 of taxable income before any Sec.
179 deduction. See’s purchases of qualifying
property were all from unrelated parties. However,
See’s taxable income before the Sec. 179 deduction
was $1,000. Therefore, if See needs to base its Sec.
179 limit on its own taxable income, the limit would
only be $1,000. However, See and Sea combined have
taxable income of $751,000 and are able to claim the
entire $500,000 expense limit for the year. Sea
could therefore claim the full $100,000 purchased,
leaving See a potential deduction of up to $400,000.
Or, the two corporations could apportion the
$500,000 differently between them, up to the cost of
qualifying property each member purchased and placed
in service during the tax year.

For an S
corporation, the taxable income limitation applies
to each S corporation separately, considering all
income and deductions for all trades or businesses
conducted by the corporation.30 However, the limit
also applies to each shareholder. Each
shareholder’s taxable income from a
trade or business includes income or loss passed
through from the S corporation.31Shareholder taxable income from a trade
or business also includes wages received as an
employee in a trade or business.32

DeductingWisely

The treatment of S corporations
as excluded members within controlled groups of
corporations provides some interesting planning
opportunities as well as an occasional pitfall.
Since S corporations are excluded members,
each S corporation within a controlled group of
corporations may claim the entire Sec. 179
expensing limit, currently $500,000. Moreover, the
amount of Sec. 179 property placed in service by other
members does not affect the $2 million limitation
reduction threshold of any S corporation. In
contrast, component members of a controlled group
must allocate a single limit and reduction
threshold.

The principal hazard is
that claiming the maximum deduction by each S
corporation within a controlled group of
corporations may overload one or more
shareholders, who will lose basis but
never receive the full tax benefit.

Thus,
although the Sec. 179 expensing election may be a
valuable option for business taxpayers, it has its
hazards. The exclusion of S corporations from
component membership in controlled groups of
corporations multiplies the planning opportunities
for businesses under common control but calls for
vigilance by tax professionals to use this deduction
wisely.

Treasury seems to have thrown some superfluous
wording into Regs. Sec. 1.1563-1(b)(2)(ii)(C) that appears to only
partially exclude S corporations from being
component members of controlled groups of
corporations. The IRS has provided guidance by
releasing its letter to the AICPA (with reference
to the AICPA redacted) that the exclusion applies
for purposes of the rules of Sec. 179. However, it may be necessary to request
specific guidance on other situations affecting
the taxation of controlled group members regarding
tax benefit items that are not specifically
contained in Sec. 1561.

12 T.D. 9522. The final
regulation clarifies that, in addition to Sec.
1563(b), paragraph (b) of the same regulation is not
taken into account for determining whether a
corporation is included in a controlled group.

Robert Jamison is
a professor of accounting in the Kelley
School of Business of Indiana
University–Purdue UniversityIndianapolis. Christopher
Hesse is chair of the AICPA S Corporation
Technical Resource Panel and a partner in
the Federal Tax Resource Group of
CliftonLarsonAllen LLP in Minneapolis. For
more information about this article, contact
Prof. Jamison at rjamison@iupui.edu.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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